Building the ETF toolbox

The use of ETFs for asset allocation has burgeoned since the financial crisis, but investors are now seeking a wider set of products, as Matthew Craig reports

In recent years, the importance of asset allocation to investment performance has become more widely recognised and arguably another reason why investors should consider the benefits of ETFs. 

One ubiquitously quoted piece of investment research shows asset allocation explains 90% of investment returns. This has led many investors, from pension funds to wealth managers, to spend more time and money on asset allocation at a strategic and tactical level. As a result, more sophisticated approaches, such as risk budgeting and liability-driven investing, are now employed as part of asset allocation in institutional investment and elsewhere. 

IFAs and wealth managers in the high net worth market are also placing more emphasis on the overall asset allocation for clients, often with the use of low-cost investment vehicles such as ETFs for the underlying investments. 

Expanding the toolset

A recent report, the EDHEC European ETF Survey 2010, looked at how investors are using ETFs in their portfolios. EDHEC-Risk Institute head of applied research Felix Goltz said the survey revealed European investors are using ETFs widely, but in many cases this is in a long-term buy and hold manner. Goltz said: “It is surprising if you think about one of the arguments for ETFs, which is their liquidity. Investors can easily buy and sell ETFs, but they are quite rarely used for dynamic asset allocation strategies where they would be very appropriate.”

Amundi ETF supported the report and the firm’s managing director Valérie Baudson said: “The recent EDHEC European ETF Survey 2010 confirmed a very high level of satisfaction towards ETFs and revealed that the European ETF market is maturing.” 

Yet the survey also highlighted a need for new products to complete the toolbox for their asset allocation. This is shown in the report by the fact that most European investment managers focus on using broad market ETFs instead of more specialist, niche products. Respondents also said they would like to see more emerging market ETFs, high yield bond ETFs and alternative asset class products developed, which would increase the scope for asset allocation. 

Goltz pointed out that ETFs can be used for tactical asset allocation, for example when ETFs give beta exposure to a particular industry sector. Or ETFs can be used as part of a dynamic asset allocation strategy, where investors limit possible downside exposure with risk controlled strategies, or where a risk budget is used to maximise the possible return for each unit of risk taken. 

However, Goltz said only 10% of survey respondents used these more sophisticated approaches to asset allocation. He said risk controlled strategies are used mainly by institutional investors and insurance companies, although private client managers were starting to adopt this approach. “Most private clients don’t want to see a drawdown, or loss, of more than 10% or 20% in a year. It is possible to create absolute return strategies using a risk controlled approach. Investors hoped to create diversification through balanced funds, but that didn’t work in 2008, so it makes more sense to have risk controlled investing, where you try to achieve a floor underpinning the portfolio,” Goltz said.

Core-satellite investing is another asset allocation approach that investors utilise ETFs for. iShares sales strategist Sofia Antropova said: “ETFs can be used as a broad core in the portfolio or for satellite investments, for example with single country funds, or difficult to access areas such as commodities.” Antropova added the liquidity and low-cost of ETFs make them efficient tools for cash equitisation, interim beta, sector rotation, rebalancing and for exposure to alternative assets. On interim beta, she said: “The investor, who is researching the market for an appropriate active manager or stock allocation, can in the meantime invest the available cash with an appropriate ETF.” 

ETFs can also be used as a beta overlay solution when, for example, one of a multi-manager’s funds has been underperforming over time, but the manager wants to keep it. Antropova said: “At rebalancing, instead of adding more investment into the underperforming fund, the manager can put cash into an ETF with the same or similar exposure, and create so-called beta overlay on the portfolio.” In addition, she said ETFs can be used as an alternative to derivatives when liquidity or counterparty risk is an issue.

Accessing asset classes

Recent market events have shown investors use ETFs in particular sectors at certain times. Antropova said: “Fixed income ETFs have seen the biggest inflows in 2010, particularly short-term government bonds and German government bonds.”

She added: “ETFs have been used for risk management. In spring 2010 clients were turning to German government bonds as an alternative to eurozone governments because the latter carried significant risk due to exposure to Greece.”

As ETFs have become more popular, the breadth of ETF coverage has grown from the main equity and bond markets to more esoteric asset classes. These now include commodities and hedge funds, enabling investors to use a single ETF, or exchange-traded product in some cases, to gain exposure to asset classes that can be otherwise illiquid and difficult to access, particularly for retail investors. 

ETF Securities head of research and investment strategy Nicholas Brooks said there has been a major shift to add commodities to the asset mix by many investors. “Since the global financial crisis in the second half of 2008, ETF Securities has more than doubled its assets under management to $20bn and about 80% of new inflows are commodity ETFs or exchange-traded commodities”. Brooks added: “In my view, it is not just a short-term phenomenon. There is a move to re-emphasising the importance of asset allocation and trying to genuinely diversify a portfolio, which will continue”. 

Brooks added the financial crisis had taught investors about the importance of liquidity. “Hedge funds were hurt by the crisis, because some hedge funds didn’t allow investors to get their money out. That is one reason why there has been a shift to ETFs.” 

In the hedge fund space, Hedge Fund Research president Ken Heinz said recent trends towards greater transparency and more nuanced tactical investing have increased the use of ETFs. He said: “More hedge fund managers are using ETFs in a strategic and tactical manner to adjust and manage their exposure. There has also been growth in ETFs that are hedge fund replication products or which use investable indices.” He added the majority of investors using these two types of ETFs were institutional or fund of funds, implementing them for tactical purposes. “It is more of a complement to an alternatives portfolio than a substitute for it. Hedge fund replication ETFs have a high level of liquidity and that has a powerful appeal to investors,” said Heinz.

While ETFs are increasingly used for tactical asset allocation, Russell Investments director of investment strategy and advice John Gillies asked: “Is tactical asset allocation a good way of increasing wealth?” He added: “Many people don’t bother to answer that question before they embark on it. People should be more aware of the pitfalls of engaging in unnecessary turnover.” Gillies said investors should ask themselves if they had a good source of intelligence that gave them an advantage in forecasting the performance of particular asset classes. 

Then, if it was felt tactical asset allocation was worth doing, Gillies said the choice of implementation tool depended on factors such as transaction costs, time horizon and management fees. For institutional investors, derivatives and index funds could also be used for tactical asset allocation as well as ETFs. “For institutional investors, ETFs are probably not as efficient as derivatives for transaction costs, but more efficient than buying and selling index funds.” However, he added institutional investors could often access index funds for very low management fees. 

Derivative limits

On the other side of the coin, derivatives may be less suitable in certain circumstances. The time horizon would affect the choice of investment vehicle, as the rollover costs for derivatives make them more expensive than ETFs over longer periods. Derivatives could also have some limitations in their coverage, as they only tend to cover large cap equities and headline indices, whereas ETFs track a more comprehensive range of asset classes. “There are trade-offs, so investors have to identify which factors are the most important to them,” said Gillies. 

Overall, it is clear the breadth and depth of ETFs now give investors a wide range of opportunities for tactical asset allocation and other investment strategies. Leveraged and inverse ETFs can also be used to increase exposure or to bet against asset classes and ETFs can be used as part of risk controlled strategies as an alternative to traditional ‘buy and hold’ approaches, which relatively few ETF investors are currently doing. 

Although the use of these funds for asset allocation has been boosted by the financial crisis, based on the need for transparency and liquidity, they are not the only tool and investors should consider all options. 

They should also satisfy themselves that strategies such as tactical asset allocation are worth doing, as the increased costs from a higher portfolio turnover could outweigh any gains made. As asset allocation is increasingly recognised as the key to successful investing, ETFs look like being an invaluable aid to investors through their versatility, liquidity and low fee structures.